As the launch date of the European Union’s updated fund legislation approaches, global custodians, and particularly sub-custodians, are increasingly concerned about its implications.

The biggest worry for custodians in the latest iteration of the undertakings for collective investment in transferable securities directive, Ucits V, is a clause that could force them to underwrite the risk of using a sub-custodian each time they enter a market. This advances the regulations beyond the responsibilities of a global custodian under the alternative investment fund managers directive.

Swen Werner, director, head of market advocacy, at Deutsche Bank’s direct securities services, said there were two possible outcomes of custodians being forced into a no-fault liability for assets: “A significant increase in costs; and where markets are too difficult to manage, we may be forced to not offer them to certain investors as part of our network.” This would result in some custodians and/or sub-custodians being forced out of, which in turn could lead to increased systemic risk associated with a concentrated market.

Werner added: “Most worrying is that it could create mispricing as investment decisions will be made based on whether a custodian can operate under that market infrastructure. We don’t want a back-office function to dictate how investors invest.”

In relation to the European custody market, the principal concern is cost, which will have to rise to cover the increased risk, and that these costs will have to be passed on to clients when margins are already under intense pressure. This could be very hard on custodians that operate principally in Europe, where the cost per trade is higher than in the US.

Paul Bodart, head of operations in Europe, the Middle East and Africa at BNY Mellon, said: “If Ucits V is in play, we will be able to go back to clients and explain that the risk of loss is up and we need to increase the price. The problem is that we are in a very competitive environment. If a family of funds puts their business up to tender, a pricing battle will ensue. It is logical to expect that fees should increase, but I am not sure if it is feasible.”

While this would certainly put the squeeze on those larger custodians with a substantial European presence, smaller custodians could find this a deal-breaker, at least in respect of Ucits funds. However, some believe that a degree of natural attrition will occur even without the pressure of Ucits thanks to other initiatives, such as Target2-Securities in 2014, aimed at harmonising settlement in Europe, and their associated costs.

Lack of partners

Beyond pure cost, the Ucits V liability clause could force custodians to pull out of some markets due to the lack of a viable partner. Günter Schnaitt, head of global securities services Austria at UniCredit, said: “We intend to modify today’s high standards in selecting a sub-custodian if we have to take on additional risk. It may lead to a situation that certain markets may not be opened when the risk is too high; an intense discussion with clients on those markets would be the consequence.”

An even greater risk is that some of the very small, specialised local sub-custodians may be squeezed out by the larger players as the regulation forces a slide to what is perceived as quality – size, and a strong balance sheet. Marty Dobbins, managing director of State Street Luxembourg, said: “When looking at choosing a sub-custodian, we want one of the major financial institutions in that market. It would have strong controls and the right service platform.”

As soon as the Ucits legislation is finalised, custodian banks will have to reassess their business and make several decisions on: the level of risk and the balance of risk and reward they will accept; the type of due diligence they do; their network and the contracts within that network; how they access a particular market and whether it is worth their while. For those global custodians willing and able to enter into new markets, Ucits V could be a boon.

Florence Fontan, head of public affairs at BNP Paribas Securities Services, said: “We have a tradition of going direct, and it is most likely that we will continue that way. If we have to insure country risk, it could significantly change our mind as we have no way to mitigate that risk.”

Global cost per trade in numbers

€3-€20 Cost of transaction process (depending on the market, its size and the level of automation)